More Trouble Ahead?

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Roughly 18 months since the collapse of the mortgage market ushered in the worst recession in nearly a century, the economy appears trapped in a vicious cycle. Companies can't get credit, so they hoard cash and minimize hiring, which in turn slows consumption, which in turn prolongs the downturn.

That cycle appears to have taken yet another turn, as reflected in the latest quarterly Duke University/CFO Magazine Global Business Outlook Survey. Optimism first began to drop in third-quarter 2007, then plunged in the following quarter. By this time last year, however, things were looking brighter: a majority of finance executives said they were more optimistic about the economy than they had been the prior quarter and, for the first time in a year, expected to see earnings grow over the following 12 months.

The most recent findings (from a survey conducted in early September), however, show optimism levels declining to levels nearly on par with those seen at the depth of the recession. Optimism about the overall economy fell at 53% of U.S. companies and increased at only 14%. Pessimists outnumber optimists four to one.

While the most recent results may not be as bleak as those recorded in early 2009, they hint at a troubling realization: CFOs may be at the limit of their ability to turn lemons into lemonade.

For much of the past two years, companies turned to layoffs and other forms of cost-cutting to stabilize — and even improve — earnings performance even as the bottom fell out of the economy. Last quarter, for example, earnings expectations for the coming year jumped 14%. And this quarter CFOs still expect earnings to rise 12% over the next 12 months, and capital spending to increase by almost 7%.

But now CFOs are beginning to identify the horizon beyond which they cannot post positive results unless the overall economy improves. One-quarter of CFOs say they can go on this way for only another 12 months, while fully half are even more pessimistic, putting the window at just 6 months.

The heart of the problem is still availability of credit. "There has been no progress in fixing the credit problem over the last year," says Campbell R. Harvey, a professor of finance at Duke's Fuqua School of Business and founding director of the survey. Half of small businesses say credit conditions are worse than in 2009.

Lack of credit prevents smaller businesses from starting the projects that create jobs, while the fear of frozen credit prompts all businesses to hoard cash. Indeed, U.S. companies are sitting on a hefty $1.8 trillion in cash, and many seem to like it that way. The survey results show 50% of respondents have no intention of deploying that cash over the next 12 months. Of those, nearly half say they will continue to sit on cash for liquidity to protect against another round of credit tightening and general economic uncertainty.

Only 22% of companies that do plan to deploy cash say that increased spending on capital and investment projects will lead to more hiring. This does not bode well for employment in 2011. In fact, U.S. firms expect full-time domestic employment to inch up by a mere 0.7% over the next year, a rate that is expected to lag the number of new workers entering the labor market. The current unemployment rate of nearly 10% seems unlikely to move down anytime soon. CFOs have been saying as much for several quarters, but the results of the most recent Duke/CFO survey underscore the degree to which the current high unemployment rate looks to be a systemic problem, perhaps the most worrisome component of the "new normal."

That's borne out by another negative employment trend — the recent surge in hiring contract and temporary employees rather than permanent workers. Nearly one-fourth of all recent hires have been contract and temporary employees. The prime suspect for this trend is the cost of health care, which once again made it onto the list of CFOs' top concerns.

Amid the gloom, it's worth remembering that the current cycle could be considerably more vicious: during the Great Depression, unemployment remained stuck at 25%, credit was impossible to obtain, deflation had a crushing impact on consumer demand, and among the very few industries able to turn a profit were alcohol and tobacco.